MANAGERIAL ECONOMICS

THE FOUNDATION OF FIRM BEHAVIOR

WHAT IS FIRM BEHAVIOR?

Firm behavior refers to the motives and range of models and different assumptions
used to seek the maximization of profit.
Rising Costs- If the cost rise, less can be produced at any given price, and the supply
curve will shift to the left.
Falling Cost- If cost fall, more can be produced, and the supply curve will shift to the
right. Any changes in an underlying determinant of supply, such as changes in the
availability of factors, or changes in weather, taxes, and subsidies, will shift the
supply curve to the left or right.
 Production Analysis and Compensation Policy
Why compensation policy is important?
The compensation policy drives the effort and performance of employees as the
employees will find the smart and easiest way how to achieve the highest possible
income with the smallest possible individual performance. The compensation policy
has to be set the smart way as it avoids the potential work around and abuse.
Cost Estimation
Cost estimation is a statement that gives the value of the cost incurred in the
manufacturing of finished goods. Cost estimation helps in fixing the selling price of
the final product after charging appropriate overheads and allowing a certain
margin for profits.

Cost Estimation Methods

Used by managers to enable the creation of cost function so that costs can be predicted at
various activity levels
Useful when fixed and variable costs are grouped together

Four common methods

 Account Analysis
 Scatter graph
 High-low
 Linear regression

Cost Analysis

What is Cost analysis?

Cost analysis is a systematic approach to
estimating the strengths and weaknesses of alternatives and cost analysis involves
comparing the explicit and implicit costs of taking an action versus expected
benefits and evaluating the desirability of a decision by weighing its potential
benefits and cost.

Various concept of cost

Real Cost – ‘the real cost of production refers to the physical quantities of various factors
used in producing a commodity.

Opportunity Cost – also called as the alternative cost is the value of a resource in
foregone employment.

Historical cost – also called as original cost, is a measure of value used in accounting in
which the value of an asset on the balance sheet is recorded at its original cost
when required by the company.

Current cost – is the cost that would be required to replace an asset in the current
period.

Explicit costs – are direct contractual monetary payments incurred

through market transactions.

Implicit costs – are the opportunity costs of the use of factors that a firm does not buy or
hire but already own.

In Implicit cost, it included the:

Wages of labor rendered by the entrepreneur himself.
Interest on capital supplied
Rent of land and premises owned by the entrepreneur
and used for production.
7. Fixed costs – also known as indirect cost, are those cost that are incurred as a
result of the use of the use of fixed factor inputs. They remain fixed at any level of
output.

Fixed cost:
Payments of rent for the building
Interest on capital
Insurance premium
Depreciation and maintenance allowances
Property and business taxes; license fees, etc.

8. Variable cost – variable costs are those costs that are incurred by the firm as a
result of the use of variable factor inputs. They are dependent on the level of
output. Opposite of fixed cost, variable cost keeps on changing with changes in the
quantity of output produced.
Prices of raw materials
Wages paid for labor
Fuel and power
Freight (or transportation) charges.
Variable cost:

Production cost – refers to all of the direct and indirect costs of the business face
from manufacturing a product or providing a service.

Production cost:
Total cost (TC)
Total fixed cost (TFC)
Total variable cost (TVC)
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
 Market Competition

Pure Competition Characteristic

Many Competing Companies- A large number of competitors that sell the same
products prevent price rising among businesses. So, producers offer their products
at an average price to stay on the market.

The same products are offered- Products may all appear to resemble each other in
packaging, color, and shape without being exactly identical. Since products are
alike, buyers may not have product preferences and often will purchase all products
equally.

Same market share for all businesses- companies can’t compete on the market due to
similar prices, they all have an equal market share.

Companies can easily enter and leave the market- Firms can enter the market
without
spending a lot of costs, time, and research. The same situation is when a seller wants to
exit the market. It isn’t required to pay some significant costs.

Monopolistic Competition
 Monopolistic competition is a type of market structure where many
companies are present in an industry, and they produce similar but
differentiated products.

PRODUCT DIFFERENTIATION
is a marketing process in which a product is differentiated from others. Is the process of
distinguishing a product or service from others making it stand out.

Types of Product Differentiation

1. Vertical Differentiation exists when consumers compare a product according to
one feature quality.
2. Horizontal Differentiation, the product is harder to classify because it has many
features.
3. Mixed Differentiation is a combination of both vertical and horizontal
differentiation.
Profit Maximization
Profit maximization is a strategy of maximizing profits with lower expenditure,
whereby a firm tries to equalize the marginal cost with the marginal revenue derived
from producing goods and services.

Monopoly
A term to describe a company that has complete or near-complete control of the
market.

Characteristics of Monopoly
1. Single Seller- the market is dominated by one particular seller/firm, usually
there are no close substitutes for the good.
2. Price Maker- Monopolist controls the quantity sold and hence has over the price.
3. Barriers to Market- No competitor can easily enter the market.

Oligopoly
A market structure in which a few sellers dominate the market. Each seller
influences the others and also considers them in decision-making. When there are
only two businesses in an Oligopoly market, it is known as a DUOPOLY.

Characteristics of Oligopoly
1. Limited Competition (number of sellers) Only a few large sellers of the same
product
dominate the market.
2. Interactivity (interdependence)-Each seller is influenced by the actions of other
sellers.
3. Oligopolies can control prices (control over price) Business has considerable
control over prices, especially when they get involved in joint decision-making.
4. Nature of the Product- Products can be homogeneous or differentiated.
5. Difficult entry
- Barriers to entry can be artificial
-Has large capital requirements to enter the market.

Misconceptions of Monopoly
Because there are no rivals selling the products of monopoly firms, they can charge
whatever they want.

Collusion of Oligopoly
The collusion of oligopoly is the prisoner's dilemma that each member faces, which
encourages each member to cheat.

Profit Maximization- Monopolists always earn positive economic profit in the long
run.

Competitive Markets
What is a Competitive Market?
Competitive market prices are determined by the interplay of aggregate supply and
demand; individual firms have no control over price.

Competitive Market Analysis

Competitive market analysis is a type of market intelligence. Gathering data on
various competitors is a necessary step in the process. In a competitive analysis of
product lines and value propositions, the company’s marketing strategy, branding,
marketing tactics, sales performance, brand equity, etc., are analyzed.

Goal of Competitive Market

The goal of a competitive market is to establish the best circumstances possible.
This way, both the buyer and the supplier profit from the sale of goods or services.

Other Market Structures

 Monopoly markets
 Monopolistic competition
 Oligopoly markets

Monopoly Market
A monopoly market is where a single firm or business enterprise produces a
product or offers a service with no substitutes.

Oligopoly Market
In an oligopoly market, most of the entire output is produced by a few players.
Characteristics of a Competitive Market
#1- The number of buyers and sellers: There are a large number of buyers and
sellers. The sellers here are usually small firms that are incapable of controlling
prices
in the market.

#2- Homogenous products: These firms and businesses manufacture products

similar to goods present in the market. This ensures a normal rate of profit for
them.

#3 – Free entry and exit of firms: No rules and regulations restrict firms from
entering the market or commencing business. Similarly, the closure of a company is
also easy.

#4- Advertising cost: As long as there is an existence of homogeneity and a normal

rate of returns, firms will not find it viable to spend more money on advertisements.

#5 – Consumers have perfect knowledge of how the market functions: Consumers

are knowledgeable and well aware of the functioning of the market. They
understand if there are any changes in the market.

#6 – A large number of buyers and sellers: All the factors of production, labor,
capital, land, and enterprises have perfect mobility in the market and are not
influenced by market factors or market forces.

#8 – Transportation costs: Transportation costs here are cheap and efficient.

#9 – Normal profits: Each firm or business earns normal profits. But, as these firms
are price takers, no firm can make super-normal profits.

Equilibrium
When a company’s output level is stable, it is said to be in equilibrium. Both
expansion and contraction are not necessary at this state. In other words, firms
hope to realize their highest possible profits by balancing their marginal costs with
their marginal revenue, or MC = MR.

Monopoly
A market structure characterized by a single seller of a highly differentiated
product.
Monopoly firms are price makers which means that Buyers and sellers whose large
transactions affect market prices.

BUYER POWER
IF ONLY A FEW BUYERS EXIST IN A GIVEN MARKET, THERE CAN BE LESS
COMPETITION THAN IF THERE ARE MANY BUYERS.
OLIGOPSONY
EXISTS WHEN THERE ARE ONLY A HANDFUL OF BUYERS PRESENT IN A
MARKET.

MONOPSONY POWER
ABILITY TO OBTAIN PRICES BELOW THOSE THAT EXIST IN A COMPETITIVE
MARKET

BILATERAL MONOPOLY
MARKETS IN WHICH A MONOPSONY BUYER FACES A MONOPOLY SELLER.

Antitrust Laws
Laws designed to promote competition

Market Niche
A segment of a market that can be successfully exploited through the special
capabilities of a given firm or individual.

Monopolistic Competition
A market structure characterized by a large number of sellers of differentiated
products.

Oligopoly
A market structure characterized by few sellers and interdependent price-output
decisions.

This market structure has some important similarities and dissimilarities with
perfectly competitive markets. Monopolistic competition is characterized by:

• Large numbers of buyers and sellers. Each firm produces a small portion of the
industry output, and each customer buys only a small part of the total.

• Product heterogeneity. The output of each firm is perceived to be essentially

different from, though comparable with, the output of other firms in the industry.

• Free entry and exit. Firms are not restricted from entering or leaving the industry.

• Perfect dissemination of information. Cost, price, and product quality information

are known by all buyers and sellers.

• Opportunity for normal profits in long-run equilibrium. Distinctive products allow

P > MC, but vigorous price and product-quality price competition keep P = AC.
Cartel
Firms operating with a formal agreement to fix prices and output.

Collusion
An informal covert agreement among firms in an industry to fix prices and output
levels.

Cournot Model
The theory is that firms in oligopoly markets make simultaneous and independent
output decisions.

Output Reaction Curve

Relation between an oligopoly firm’s profit-maximizing output and rival output.

Duopoly
The market is dominated by two firms.

Stackelberg Model
Theory of sequential output decisions in oligopoly markets.

Price Signaling
Informal collusion by announcing pricing strategy in the hope that competitors will
follow suit.

Price Leadership
The situation in which one firm establishes itself as the industry trendsetter and all
other firms in the industry accept its pricing policy.

Another type of price signaling is BAROMETRIC PRICE LEADERSHIP. In this

case, one firm announces a price change in response to what it perceives as a
change in industry supply and demand conditions.

Contestable Markets Theory

The hypothesis is that oligopoly firms will behave much like perfectly competitive
firms when sunk costs are minor.

Sweezy Model
The theory explains why an established price level tends to remain fixed for
extended periods of time in some monopoly markets.
Kinked Demand Curve
Firm demand curve that has different slopes for price increases as compared
with price decreases.

Economic Census
A comprehensive statistical profile of the economy, from the national to the state,
and to the local level.

Concentration ratios measure the percentage of the market share held by

(concentrated in) a group of top firms.

Herfindahl–Hirschmann Index (HHI) is a measure of competitor size inequality

that reflects size differences among both large and small firms. Calculated in
percentage terms, the HHI is the sum of the squared market shares for all n
industry competitors.

Production Analysis and

Compensation Policy
(Chapter 7)

Returns to Scale and Returns to a Factor

Difference? Returns to a factor examine the effects on output when only one factor
is increased while assuming other factors to be constant. Returns to scale examine
the effects on output when all the factors are increased simultaneously in the same
proportion.
 Cost Analysis and
Estimation
(Chapter 8)

Sunk Costs

 Inherent in the incremental cost concept is the principle that any cost not
affected by a decision is irrelevant to that decision.
 A cost that does not vary across decision alternatives.
 Do not play a role in determining the optimal course of action.
Example: For example, suppose a firm has spent $5,000 on an option
to purchase land for a new factory at a price of $500,000. Also
assume that it is later offered an equally attractive site for $400,000.
What should the firm do?
 LINEAR
PROGRAMMING

A solution method for maximization or minimization

decision problems subject to underlying constraints.

 a problem-solving approach that consists of linear relationships

representing a firm’s decision(s). given an objective and resource
constraints.

 The typical model consists of the set of linear equations and/or

inequalities(constraints) and the linear objective function (which is to
be maximized or minimized.) The non-negativity constraints
(variables are zero or positive) are mostly involved in the model.

 The managers goal is to find optimal solution with the best value of
the objective function.
 NATIONAL INCOME ACCOUNTING

National Income
 Also known as GROSS NATIONAL INCOME.
  It is the total income earned by all residents and enterprises of a
country over a specific period.
 It can also as the total value of all goods and services produced over a
specific period of time.

Three Most Common Methods in solving the National Income

 Value-added Method (Product Method) – focuses on the value added to a
product at each stage of its production.
 Income Method – focuses on the income received on the factors of
production such as land and labor.
 Expenditure Method – focuses on the various types of expenditure based
on consumption and investment.
MEASURES OF INCOME

Gross domestic product (GDP) = C + I + G + NX

Gross national product (GNP) = GDP + Z (income that our citizens
earn abroad - income that foreigners earn here)
Net national product (NNP) = GNP – losses from depreciation
National Income (NI) = NNP + B (business subsidies - indirect business
taxes (such as sales taxes))
Personal Income (PI) = NI – payroll taxes (social security
contributions) – corporate income taxes – undistributed corporate
profits(retained earnings) + interest income that households receive
from their holdings of government debt + transfer payments
Disposable personal income (DPI) = PI – personal taxes – certain
nontax payments (such as traffic tickets)